Being a collection of thoughts, observations, comments, opinions and views on investing--especially for the long term.
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Wednesday, March 23, 2005

Do Higher Interest Rates Lead to Lower Stock Prices?

A couple of posts ago I looked at the impact of inflation on the stock market and concluded that the correlation really is very weak, i.e., higher inflation does not "normally" lead to lower (nor higher) stock prices. Today I take a look at interest rates, in an effort to find some historical evidence to support the general market sentiment that higher interest rates "cause" lower stock prices.

Common economic "theory" says that, as interest rates rise, stock prices should fall, since investors will demand a higher return on investment (i.e., investors will now pay less for a given future earnings stream) in a higher interest rate environment. Offhand, this logic seems plausible. As interest rates rise, bond prices fall--and so should stock prices, since stocks are a "substitute" investment for bonds.

To see if history supports these common investor beliefs, I took a look at interest rate (10-year Treasury) and stock price (S&P 500) data for the past two centuries:

Note: "% change" is defined as (R2-R1)/R1, where R1 and R2 are rates or prices in consecutive years.

For this 204-year period, the correlation between interest rates and stock prices has generally been weak, based on annual data. Rising interest rates have been accompanied by falling stock prices just as often as they have by rising stock prices. Quartile data also do not show any pronounced pattern with a strong enough correlation coefficient to lend support to a cause-effect relationship.

Nor is there any obvious pattern among the years with the largest percentage changes in interest rates:

For example, in 1999, the 10-year Treasury rose in yield from 4.65% to 6.45% (a 38.7% rise, making it the highest percentage change among all 204 years in the study!); yet, instead of falling, the S&P 500 rose sharply by 19.5%.

These data certainly do not indicate any "obvious" relationship between interest rates and stock prices. In other words, the belief that stock prices should fall because interest rates rise is not well supported by historical evidence.